What Is an Annuity? A Complete Guide to Become an Expert

An annuity is a financial product offered by insurance companies. It helps individuals grow their savings and convert them into predictable income payments, typically used for retirement planning.

Annuities have been around for a long time, and their name comes from the Latin word “annus,” meaning “year.”

Annuities Have Been Around Since Ancient Rome

The first recorded use of annuities can be traced back to Ancient Rome, where citizens entered into agreements called annua. These agreements involved a lump sum payment to receive annual payments for a specified duration, often for life. Roman soldiers and their families were some of the earliest beneficiaries of these arrangements.

Thus, annuities were originally created to provide annual income payments. Simply put, they’re designed to take a lump sum of money and turn it into regular payments you can count on for life. The best part? An annuity can help ensure you’ll never outlive your income. It’s a reliable way to create financial security and peace of mind for the future.

The History and Growth of Annuities in the United States 

Annuities were first introduced to the U.S. market in the mid-18th century but gained significant traction during the 1930s amidst the Great Depression. With historically low interest rates and economic uncertainty, Americans sought secure and reliable income sources, making annuities an attractive option. By 1933, there were approximately 300,000 active annuity contracts in the United States, marking the beginning of their widespread adoption. 

Definition and Purpose of Annuities

Definition: Per Investor.gov, "An annuity is a contract between you and an insurance company that requires the insurer to make payments to you, either immediately or in the future. You buy an annuity by making either a single payment or a series of payments. Similarly, your payout may come either as one lump-sum payment or as a series of payments over time."

The Purpose of Annuities

Annuities can seem complicated, with their mix of features, benefits, and drawbacks. But don’t worry—at PlanEasy, we’re here to make it simple. Our goal is to help you understand how annuities work so you can feel confident in making the right decision for your financial future. Let’s break it down together.

An annuity is a smart way to get:

1. Tax-Deferred Accumulation: You can grow your savings in a tax-deferred manner, so that your dollars go further.
2. Guaranteed Income: It can provide a steady, guaranteed income—either for life or for a set period—giving you financial security and peace of mind.

Deferred annuities are one of the most popular types of annuities, offering a powerful combination of benefits: tax-deferred growth and guaranteed income.

What Are Deferred Annuities? 

A deferred annuity is a long-term financial product that helps you secure income for retirement by growing your savings over time. Designed for future financial stability, it’s not ideal for short-term saving or immediate income needs.

How Do Deferred Annuities Work? 

These annuities serve as savings and investment tools, offering tax-deferred growth of funds for future use. While their primary purpose is to build savings for an individual's lifetime, they also provide secondary death benefits. 

Types of Deferred Annuities - Choosing Your Options

Deferred annuities provide flexible options to match different investment profiles and objectives.

• Fixed and Indexed Annuities: Conservative options ideal for "safe money" needs, offering principal protection, stable growth without market risk. 
• Variable Annuities: Designed for those seeking potential market-based growth and returns, though these come without guarantees. 

Another type of annuity that is not a deferred annuity is an immediate annuity, which immediately provides income within a year. Both deferred and immediate annuities offer reliable ways to create a steady income stream tailored to your financial goals, lasting as long as you choose.

What Is Tax-Deferral and How Does it Work?

Tax deferral allows annuity contract owners to grow their savings faster during the accumulation phase by postponing taxes. Here’s why it’s impactful.

In a taxable account, such as a savings account, CD, or mutual fund, income is taxed annually. For example, if an account earns $100,000 in a year and the account owner is in the 22% tax bracket, they owe $22,000 in taxes ($100,000 × 0.22 = $22,000). That $22,000, once withdrawn to pay taxes, can no longer earn interest or generate further growth. 

With tax deferral, the income earned in an annuity is not taxed annually. Instead, taxes are deferred until withdrawals are made. This means the entire $100,000 stays in the account, continuing to compound and grow over time. 

By avoiding the annual tax drain, tax-deferred accounts offer a powerful way to maximize long-term savings and achieve greater financial growth compared to taxable accounts.

How can the way income is taxed significantly impact your long-term investment growth? In a traditional taxable account, income taxes are due on any earnings—whether or not you’ve actually received them. For instance, interest earned on a certificate of deposit (CD) is considered taxable income the year it's credited, even if the money remains in the account and isn’t withdrawn. This reduces the amount you can reinvest, which limits your earning potential over time.

With tax-deferred annuities, the story is different. Here’s how they work: The interest credited to your annuity grows tax-deferred, meaning you don’t pay taxes on the earnings until you withdraw them. This allows the full amount of your earnings to stay invested, compounding even further. Over time, this tax-deferral advantage can result in significantly higher after-tax returns compared to a taxable account.

Example:

Let’s consider an example with the following assumptions:

• An initial contribution of $100,000
• A tax rate of 30%
• An annual interest rate of 6.00%

In a taxable account, the income earned would be reduced by the 30% tax liability each year. This means that for every $1,000 in interest earned, $300 is paid in taxes, leaving $700 to reinvest. However, in a tax-deferred annuity, the entire interest amount remains invested and continues to compound, creating a snowball effect over the years.

The Long-Term Impact of Tax Deferral

Here’s what happens when we let these accounts grow for 5, 10, 15, 20, 25, 30, 35, and 40 years.

Growth Comparison: Taxable vs. Tax-Deferred Accounts (6.00% Growth, 30% Taxes)

This table highlights how tax-deferred growth outpaces taxable growth over time, with the gap widening significantly as compounding continues. As the table shows, after 40 years, the amount you can withdraw from your tax-deferred annuity, even after withdrawal taxes of 30%, far outpaces the taxable account by almost $250k ($750,000 - $518,452 = $231,548), nearly 50% more the taxable account value. 

This difference occurs because the money that would have gone toward annual taxes in the taxable account stays invested and earns interest in the tax-deferred account. Over decades, this compounding amplifies the gap significantly.

Tax-Deferred Doesn’t Mean Tax-Free

It’s important to note that tax-deferred growth is not the same as tax-free growth. When you eventually take distributions from the annuity, you’ll owe income taxes on the earnings. However, the tax deferral allows your investment to grow substantially more over time, often resulting in a much larger after-tax balance compared to similar investments in taxable accounts.

Key Takeaways for Investors

1. Maximize Compounding Potential: Tax-deferred annuities allow all your earnings to compound without immediate tax deductions, boosting long-term growth. Taxable accounts like savings and CDs do not have this benefit, as interest income is taxed each year.
2. Plan for Tax Obligations: While taxes are deferred, they will eventually need to be paid. Consider your future tax bracket when making decisions about distributions.
3. Long-Term Growth Advantage: Over decades, the tax-deferred growth can result in significantly higher after-tax returns compared to taxable accounts.

Ensure an Income You Can’t Outlive with Annuities

When planning for retirement, one critical challenge is ensuring your savings last throughout your life, no matter how long you live. Annuities offer a unique solution: they provide an income stream that you can’t outlive, offering peace of mind and financial stability in your golden years. 

Income You Can’t Outlive: The Key Advantage of Annuities

While tax deferral and the ability to reallocate assets within an annuity are notable benefits, the primary advantage is the guaranteed lifetime income they can provide. Whether you live 20, 30, or even 40 more years, annuities ensure you’ll continue receiving payments, removing the worry of running out of money.

Why Longevity Risk Matters

Let’s break it down with an example. Suppose you’re 65 years old and have $500,000 saved for supplemental retirement income. You want to ensure this money supports you for the rest of your life, but you have no way to predict exactly how long you will live. Here are some common strategies and their risks:

• Money Market Accounts

If you invest your $500,000 in a money market account with a 4% interest rate, you’d earn $20,000 annually without touching the principal. While this approach ensures you’ll never run out of money, living on $20,000 a year may not be enough to cover both necessities and occasional luxuries.

• Drawing Down Principal Based on Life Expectancy

According to actuarial tables, the average life expectancy at age 65 is about 20 years. Using this, you calculate that you can withdraw $35,000 annually, combining principal and interest, assuming a steady 4% return. However, if you live beyond 20 years, your savings will be depleted, leaving you without income when you need it most.

• Higher-Risk Investments

To increase your annual income, you could invest in higher-risk assets, such as high-yield bonds (junk bonds), aiming for a 6.5% return. This could boost your annual withdrawals to $45,000 for 20 years. But this approach comes with two significant risks: 

• Market Risk: Your investments may lose value during market downturns or if interest rates rise. 
• Longevity Risk: If you outlive your 20-year plan, you risk outliving your savings entirely.

Annuities: A Safer Alternative

Annuities eliminate the risk of outliving your money. At age 65, you could use your $500,000 to purchase a fixed index annuity (FIA) with a lifetime income benefit rider (LIBR) or a single premium immediate annuity (SPIA). Depending on the insurer and your gender, this could provide you with annual lifetime payments possibly ranging from $25,000 to $35,000, depending on current interest rates. Even if you live 30 or 40 more years, these payments continue, ensuring financial stability no matter how long you live.

One thing to note is that a FIA wit an guaranteed lifetime income rider is such that the annuity always belongs to the owner. If the owner wanted to surrender the annuity in the case of an emergency, he or she could do so and retrieve the account value net of surrender charges, if any. For a SPIA or a deferred income annuity (DIA), however, once the owner buys the annuity and gives the premium to the insurer, the annuity no longer belongs to the owner with all of the contributed funds instead now belonging to the insurer.

The Bottom Line

Annuities offer a unique and powerful solution for retirement planning. By ensuring an income stream you can’t outlive, they provide financial stability and eliminate the fear of running out of money. Whether you’re concerned about longevity risk, market volatility, or simply wanting a reliable retirement income, annuities can help you achieve peace of mind. To find out more, consult with PlanEasy to see if an annuity aligns with your goals and lifestyle. 

Key Summary:

• Tax-Deferred Growth: Allows savings to grow without immediate tax implications. 
• Guaranteed Lifetime Income: Eliminates the risk of outliving your money. 
• Customizable Options: Choose fixed or variable payouts depending on your needs. 
• Retirement Security: Provides peace of mind no matter how long you live. 

Types of Annuities: A Brief Overview

Annuities are versatile financial tools designed for both wealth accumulation and income distribution. They come in various types, offering flexibility to suit different financial goals and situations. We’ll now explore different types of annuities, their features, and how they are classified. Whether you're looking to invest in different annuities or better understand annuity types, this overview will help you make informed decisions.

Common Characteristics of Annuities

While annuities may differ in structure and purpose, they share some key characteristics. Most annuities are categorized based on their premium structure, timing of payouts, and whether they are fixed or variable. Here, we’ll break down the major annuity types and their key distinctions.

Types of Annuities Based on How Premiums Are Paid

1. Single Premium Annuities

Single premium annuities require a one-time lump-sum payment. These are ideal for individuals who have a large sum to invest, such as funds from an inheritance, a severance package, or a pension plan payout. The two main types of single premium annuities are:

• Single Premium Immediate Annuities (SPIA): Begin payments immediately after the premium is paid.
• Single Premium Deferred Annuities (SPDA): Allow the investment to grow over time before payouts begin.

2. Flexible Premium Annuities

Flexible premium annuities allow for multiple, ongoing contributions over time. This option is perfect for those who prefer to invest as their finances allow rather than committing to a single large payment. Key features include:

• The ability to pay premiums at your own pace, depending on your cash flow.
• Regular premium notices from the insurer, though you can choose to pay more, less, or skip payments altogether (subject to minimum and maximum limits set by the provider).

Type of Annuities Based on Timing of Annuity Payouts

Annuities may also be classified as deferred annuities or immediate annuities. The difference between the two relates to when benefits are paid out.

• Deferred Annuities: Deferred annuities are designed for long-term growth, with payouts beginning at a future date. They can be funded through either single or flexible premiums. This makes them a popular choice for retirement planning.
• Immediate Annuities: Immediate annuities begin payouts almost immediately after the initial premium is paid. These are typically funded with a single premium and are suited for individuals seeking an immediate income stream.

How Different Annuities Grow and Accumulate Cash Value: Methods of Interest Crediting

Annuity contracts can accumulate via three main types:

1. Fixed Annuities a.ka. Multi-Year Guaranteed Annuities (MYGAs);
2. Fixed Index Annuities (FIAs); and
3. Variable Annuities (VAs).

The key difference lies in how interest is applied to the annuity's cash value and whether principal is protected. Fixed annuities are principal-protected and offer a guaranteed interest rate, fixed index annuities credit interest based on the performance of a specific market index, such as the S&P 500, while variable annuities are not principal-protected with values that fluctuate based on market performance. Understanding these distinctions is crucial when choosing the right annuity for your financial goals.PlanEasy specializes in MYGAs and FIAs, having had extensive experience designing both products and running an annuity insurer.

Below is a tabular summary of the differences between each product with further details discussed after.

Fixed Annuities vs. Fixed Index Annuities vs. Variable Annuities - How Each Grows

Let's dive into each in further detail.

Fixed Annuities: A Stable, Guaranteed Option

Fixed annuities are principal-protected, ensuring the value of your annuity doesn't go below the amount of premiums you contributed, unless the annuity is surrendered during the surrender charge period. Fixed annuities are also called MYGAs or fixed rate annuities.

• Declared-Rate Fixed Annuities a.k.a. Multi-Year Guaranteed Annuities (MYGAs): Interest is based on the insurer's rate declarations and is guaranteed over a term, while the value of your principal is protected.

As mentioned above, a fixed annuity offers security by guaranteeing that your principal won’t be lost, regardless of market performance. In this type of contract, the insurer assumes the risk, not the contract owner. Key features include:

• Guaranteed Principal: Your original investment is always protected.
• Minimum Interest Rate: A fixed annuity guarantees at least the minimum interest rate specified in the contract.
• Current Rate: Insurers often credit a higher interest rate (above the guaranteed minimum), called the current rate. This interest rate credited to your annuity may depend on:
• The insurer's board of directors' declaration, which takes into account the current interest rate environment, competitive dynamics, and the insurer's ratings.

What Are Fixed Index Annuities? Principal Protected With Market Performance

A fixed indexed annuity or indexed annuity combines elements of fixed annuities and variable market performance. While the insurer assumes the riskand protects your principal, the interest credited to the annuity is based on changes in a specified index, such as the S&P 500. Key components include:

• Index Term: The period during which the cash value is allocated to the index strategy or strategies, if the allocations are diversified.
• Unadjusted Index Interest Rate: The raw interest rate calculated from the market index's performance before adjustments like cap rates, participation rates, or performance trigger rates.
• Adjusted Index Interest Rate or Credited Interest Rate: The amount of interest credited to the annuity's value for a given period based on the adjustment method applied to the gross performance of the reference market index.

How Does It Work?

A common method to calculate interest for indexed annuities is the point-to-point method:

1. Start with the index's closing level at the beginning of the term, such as a year.
2. Compare it to the closing level at the end of the term.
3. Convert the difference into a percentage (unadjusted index interest rate).

Example: 

If the index level starts at 1000 and rises to 1200 by the end of the term:

• The increase = 1200 - 1000 = 200.
• Unadjusted interest rate = 200 ÷ 1000 = 20%.

If the participation rate(par rate) is 100% and no other adjustments apply, the credited interest rate would be 20%. If the par rate was 60%, the credited interest rate would be 12%. Any negative return on the index would result in a 0% crediting rate such that your annuity will never go below its principal value.

If the index annuity was using a cap rate of 7%, then the 20% increase in the index would be capped at 7%, which would be credited to your annuity's cash value. Negative performances in the index result in 0% interest credited. 

A third, though less common, method of crediting interest is a performance trigger. If there was a performance trigger rate of 4%, then anytime the index performance is positive, you would get 4% interest credited. If the index declines over the measurement term, you'd get a 0% crediting rate.

What Are Variable Annuities? Owner Assumes Investment Risk

In variable annuities, premiums are allocated by the owner to different accounts, and the accumulated value depends on the performance of these allocations. When allocating premiums to a separate account or a structured account, variable annuities are an insurance product where the contract owner assumes the investment risk of losing principal. This is unlike fixed annuities and fixed index annuities where the insurer bears the risk and the owner is guaranteed principal protection. A variable annuity also gives the option of allocating funds to a fixed account, which does however guarantee principal and is similar to a fixed annuity.

Here's how variable annuities work:

Allocation Options for Variable Annuities:

• Separate Accounts: 

Funds in separate accounts are invested in variable subaccounts, which are diversified by:

1. Objective (e.g., income, growth)
2. Asset class (e.g., stocks, bonds)
3. Risk level 

Subaccounts may include portfolios such as: 

• Common stock portfolios 
• Bond portfolios 
• Money market funds 

The value of the separate account depends on the positive or negative performance of these subaccounts, managed by professional fund managers. 

• Fixed Accounts: 

Similar to traditional fixed annuities, fixed accounts guarantee both the principal and a minimum rate of interest. These provide lower risk but also lower potential returns when compared to separate accounts. 

• Structured Accounts: 

Newer variable annuity products introduce structured accounts, where the change in value of allocated premiums is tied to the positive or negative performance of an equity or commodity index, limited by a cap on the upside or loss buffer on the downside. These accounts are typically locked for a specified term, such as 1, 3, or 5 years, known as the "structured segment."

What Are Structured Account Options in Variable Annuities?

Structured account options in variable annuities offer a unique investment approach, blending features of fixed indexed annuities with key differences. These options allow contract owners to allocate premiums to investment segments tied to equity or commodity index performance. However, unlike fixed indexed annuities that guarantee principal protection, structured accounts do not guarantee principal and may result in a loss. To mitigate potential losses, insurers often provide a downside buffer.

Variable Annuity Accounts: A Summary

How Do Variable Annuity Structured Account Options Work?

When premiums are allocated to a structured account segment, returns are influenced by the performance of a linked index, subject to a cap rate (the maximum return allowed) and a buffer (protection against losses). Here’s how it works:

• Positive Performance Example: 

Imagine a contract owner allocates premiums to a one-year structured segment based on an equity index starting at 1000 and ending at 1300. The unadjusted interest rate is 30% (1300 - 1000 = 300; 300 ÷ 1000 = 30%). However, if the segment has a 15% cap rate, the return is capped at 15%, despite the 30% unadjusted rate.

• Negative Performance Example: 

Now suppose the same index declines by 35% from 1000 to 650. If the insurer provides a 10% downside buffer, only 25% of the loss impacts the premiums (35% - 10% = 25%). This buffer helps soften the blow of adverse market performance.

Key Features of Structured Account Options

• Cap Rate: The maximum return a segment can generate, even if the index performs better. 
• Downside Buffer: Insurer absorbs part of the loss if the index declines, typically 10%, 20%, or 30%. 
• Segment Variety: Contract owners can select from multiple segments with varying durations, cap rates, and buffers to tailor their investment strategy. 

Why Consider Structured Accounts?

Structured accounts offer a balance between growth potential and risk management. However, it's crucial to understand that they do not guarantee principal protection like fixed indexed annuities.

In Conclusion: Implications for Annuity Owners

As we’ve discussed, annuities provide tax deferral benefits, guaranteed income, and varying levels of risk and opportunity for contract owners. Here's a breakdown of the three main types and key differences among them:

• Fixed Annuities: Offer the highest level of guarantees, including protection of principal and previously credited interest, regardless of market performance. Interest is credited at a guaranteed rate, though inflation risk (purchasing power erosion) remains a concern.
• Fixed Index Annuities: Credit interest based on market index performance (e.g., S&P 500) while protecting the principal from loss, even if the index drops. Though interest guarantees are lower than fixed annuities, they offer some inflation protection.
• Variable Annuities: Provide the highest potential returns but come with the greatest risk. Contract owners can allocate premiums to various investment options, such as stocks or bonds, with no guarantees against loss, except for premiums allocated to the fixed account.

Advantages and Risks of Each Type of Annuity

Choose the right annuity based on your financial goals and risk tolerance. We at PlanEasy can help.